How one-time fixes can lead to municipal bankruptcy

Guest Column: Josh Barro

Last week, the Stockton, Calif., City Council approved a petition for bankruptcy, the largest of a city in U.S. history. Municipalities all over the country are in fiscal distress, but few are actually declaring bankruptcy. What went so badly wrong in Stockton, and what lessons can other cities learn?

How one-time fixes can lead to municipal bankruptcy

Last week, the Stockton, Calif., City Council approved a petition for bankruptcy, the largest of a city in U.S. history. Municipalities all over the country are in fiscal distress, but few are actually declaring bankruptcy. What went so badly wrong in Stockton, and what lessons can other cities learn?

The best overview of Stockton’s troubles comes from California Common Sense, a think tank that identifies the factors that combined to drive the city into bankruptcy:

First, Stockton had a huge property bubble, with median home prices rising 200 percent between 2000 and 2006. This flooded the city’s coffers with property tax revenue. Assuming the trend would continue, officials signed employee contracts that proved unaffordable. The city even agreed to a “heads you win, tails we lose” pay structure tied to the city’s tax receipts: In strong revenue years, workers got 7 percent raises, but even if revenue declined, they got 2.5 percent raises.

Then Stockton had a huge property bust. The median home price in Stockton fell 70 percent from 2006 to 2009 (i.e., back to 2000 levels). In many states, municipalities raise property tax rates when values fall. That’s illegal in California, so plummeting home prices meant plummeting tax receipts. But even as tax receipts were falling, compensation costs per employee continued to rise. In recent years, the city sharply cut headcount, but still could not close its budget deficits.

Making matters worse, says the think tank, in 2007 Stockton issued $125 million in pension-obligation bonds. As in other jurisdictions that tried to “fix” their pension problems with bonds in the last decade (see Woonsocket), this backfired: The assets Stockton bought with the bond proceeds declined in value, and the city is stuck with both a pension liability and a bond liability. And that pension liability has been a major driver of the city’s insolvency.

None of these factors was unique to Stockton. Their combined severity, however, was. For example, in the last decade San Jose, Calif., has seen pension costs skyrocket and signed some regrettable employee contracts. But the economy there has held up better and the decline in property values has been more mild. As a result, the city has identified a path to fix its finances without bankruptcy.

California has several options to prevent more Stocktons. First, the state needs to restructure and relax its Proposition 13 property tax limit, which limits property tax to no more than 1 percent of property value, and in practice often to significantly less. The state needs a regime that allows cities like Stockton to raise taxes when necessary, and that prevents booms and busts in property tax revenue.

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